The hedge fund industry in the United States has evolved from a niche market participant in the early 1950s to a major industry operating in international financial markets today. Hedge funds in the United States were originally privately-held, privately-managed investment funds, unregistered and exempt from federal securities regulation. With increasing investor demand for hedge funds and significant growth of the hedge fund industry came a tectonic shift in the regulatory framework applicable to the industry.
Several core features characterize the hedge fund industry. A hedge fund’s goal is to earn for its investors a high rate of return on their capital contributions through sophisticated trading strategies in securities, currencies, and derivatives. Historically, hedge funds operate with a relatively short “lock-in,” the amount of time an investor must commit money pledged to the fund. Hedge funds that lose money, and a large proportion do, simply wither away. Because of the emphasis on performance, the hedge fund industry may be labeled a “survival of the fittest” industry. The fund manager takes a 1-2 percent management fee and 20 percent of the fund’s profits (the carry). A successful manager usually establishes a number of distinct, follow-up funds. If a fund manager earns lackluster returns, the investors pull their capital and will not support the manager’s effort to raise new funds.
The core characteristics of the hedge fund industry give rise to a variety of concerns over hedge funds:
(1) People who fear concentrations of money see hedge funds as too large. Hedge funds have grown rapidly, both in number and size. Hedge funds also tend to operate in loose cooperation, like wolf packs.
(2) People who distrust the wealthy elite see hedge funds as the exclusive playground of a very wealthy elite class of investors. These wealthy investors appear to be making double-digit returns not available to normal investors.
(3) People who fear secret conspiracies see hedge funds as insufficiently transparent. Ben Bernanke, former chairman of the Federal Reserve System, has described them as “opaque.” If they comply with applicable exemptions from federal securities regulation, hedge funds do not have to disclose their membership or their investment strategies, which depend on speed, cleverness, and leverage.
(4) People who do not like sharp lenders of last resort believe some hedge funds are vultures, demanding confiscatory terms from those in dire financial situations.
(5) People who condemn risk-taking see hedge funds as a form of gambling. Hedge funds can use leverage to generate high returns. They can borrow from banks and other sources to fund their trading strategies. Although many of the funds have shown significant returns, a few have been spectacular failures. When their strategies fail, hedge funds can produce losses not only for their members but also for their lenders and counterparties.
(6) People who suspect fraud in multifaceted financial scenarios find hedge funds too complex. Hedge funds can play the short side of the market, raising old prejudices against short sellers, and they often engage in sophisticated trading maneuvers, using cutting edge financial products. Because the complex trading maneuvers can take advantage of loopholes in the existing regulatory framework, some see foul play involved. A number of troubling incidents of fraud perpetrated by hedge fund operators caused the SEC to lists fraud as one of its primary reasons for its new hedge fund regulations.
(7) People who are suspicious of “get-rich-quick, guaranteed” sales pitches believe that hedge funds may be duping their own investors with false promises of easy money. Colleges such as The College of Wooster in Ohio have over 80 percent of their entire endowment in hedge funds, to the consternation of some of their alumni who wonder whether the college officials are overmatched when responding to hedge fund solicitations.
(8) People who value market stability in the securities and currency markets worry that hedge funds add to market volatility that is unrelated to fundamental market values and that they contribute to market bubbles and panics.
(9) People with positions in traditional operating companies can see “activist” hedge funds as threatening. Some hedge funds take an “activist” investor tack, attempting to influence the incumbent management in blue chip companies such as Time-Warner Inc., Wendy’s, McDonalds, Knight Ridder, Inc., and General Motors. These actions have aroused the attention and ire of main street managers and their lawyers.
This combination of concerns about hedge funds–large size, elite investors, lack of transparency, perceptions of predatory behavior, high risk and periodic spectacular failure, complexity, perceived false promises of easy money, volatility, and attacks on established interests–can foment popular fear of a new breed of shadowy financial players. The populist anti-hedge fund spin almost writes itself: a wealthy, backroom, elite group of investors, driven by selfish greed, takes excessive risks with cheater-style trading strategies that imperil the health of our banks and our corporations – our entire economy. And popular fear created pressure for government regulation of the industry.
THE REGULATORY FRAMEWORK ORIGINALLY APPLICABLE TO HEDGE FUNDS IN THE UNITED STATES
At the beginning of the industry in the early 1950s, organizers of hedge funds designed the funds to be exempt from the public offering registration requirements of the Securities Act of 1933, the periodic reporting requirements of the Securities Exchange Act of 1934, the registration requirements of the Investment Company Act of 1940, and the registration requirements of the Investment Advisers Act of 1940. The exemptions gave United States hedge funds substantial freedom in their investment activities.
The typical hedge fund manager raises money from wealthy individuals and institutional investors using an exemption for “private offerings” under the Securities Act of 1933 in Rule 506 of Regulation D. Most early hedge funds satisfied the exemption by marketing themselves only to “accredited investors,” institutional investors, insiders, or natural persons with a net worth of over $1 million or income over $200,000 for each of the last two years. Funds that used Rule 506 were prohibited from using any form of “general solicitation or general advertising.” The SEC applied a “pre-existing, substantive relationship” test when deciding that the general solicitation rule has not been violated.
Moreover, a hedge fund was careful to avoid classification as a financial market player that is specifically regulated by the federal legislation. A hedge fund, for example, is not an underwriter, a market maker, or a broker-dealer (market intermediary). A bank or investment subsidiary of an operating company is not a hedge fund. Hedge funds were also careful, by having fewer than 500 investors, to avoid the periodic reporting obligations of Section 12 of the Exchange Act and SEC Rule 12g-1.
The most important regulatory exemption for hedge funds is found in the Investment Company Act of 1940, an act that regulates mutual funds. Hedge funds rely on one of two statutory exclusions in the definition of an investment company. Hedge funds either have fewer than 100 investors or have only investors that are “qualified purchasers,” i.e., individuals who own over $5 million in investments or companies with over $25 million in investments. A hedge fund that comes within one of these statutory exclusions may use investment techniques that are forbidden to the registered investment companies. The most notable technique that is more freely available to hedge funds than other specifically regulated financial entities is “shorting,” betting on decreases in value in asset classes.
Most hedge fund investment strategies are complex, involving a combination of several coordinated trading positions to make the desired market play. Several of the strategies have common names. In “convertible arbitrage,” for example, a hedge fund goes long in convertible securities (bonds or shares that are exchangeable for another form of securities, usually common shares, at a pre-set price) and simultaneously shorts the shares. In “merger arbitrage,” a hedge fund buys target company stock and shorts the stock of the purchaser. In “global macro” plays, a fund takes a long position in one country’s currency and shorts the currency of another (this is also done with government debt). In “market neutral” plays, a fund takes offsetting long positions in undervalued companies and short positions in overvalued companies.
Hedge funds can also structure their operations to avoid other regulations. Hedge funds also typically avoid the regulation of “commodity pools” by the Commodity Futures Trading Commission (CFTC). New CFTC rules exempt pools that sell only to sophisticated participants, “accredited investors” under Regulation D or “qualified purchasers” under the Investment Company Act. Hedge funds avoid regulation under the Employee Retirement Income Security Act (ERISA) by limiting the ownership interest of any employee benefit plan to less than 25 percent of the fund.
CHANGES TO THE INITIAL REGULATORY FRAMEWORK
The New SEC Rules Requiring the Registration of Hedge Fund Managers
Since the growth of the hedge fund industry in the 1980s, the SEC had repeatedly attempted to register hedge fund advisers. Its last attempt at registering them in 2004 was vacated as arbitrary by the United States Court of Appeals for the District of Columbia in Goldstein v. SEC in 2006. Although the vast majority of hedge fund advisers had registered under the SEC’s registration requirements, they immediately deregistered after the Goldstein decision. The advisers’ decisions to deregister in 2006 seems to confirm the industry’s opposition to registration and disclosure requirements.
Because of hedge funds’ alleged impact on the markets in the 1969 bear market, the SEC started to consider ways to bring them under its regulatory authority. Initially, the SEC opined that hedge funds are “dealers” in securities, which could require registration under the Securities Exchange Act. However, the SEC continued to provide guidance, mostly in the form of no-action letters, to help investment advisers determine how to count clients to stay exempt from securities regulation. Courts provided very limited and sometimes contradictory guidance.
Finally, in 1985, the SEC adopted the investment adviser registration safe harbor in Rule 203(b)(3) under the Investment Advisers Act. For purposes of an exemption from registration under that act, the safe harbor allowed a limited partnership, rather than each of its limited partners, to be counted as a “client” of a general partner acting as investment adviser to the partnership. Justifying the rule, the SEC reasoned that if an investment adviser manages an investment pool on the basis of the investment objectives of its participants, the entire pool should be viewed as the adviser’s client rather than each participant. The rule was aimed at providing investment advisers with greater certainty in determining when they might rely on the safe harbor.
The SEC broadened the scope of the rule in 1997 by including other entities used by investment advisers to pool client assets. While the 1985 Rule permitted advisers to count each partnership, trust, or corporation as a single client, the 1997 Rule expanded the rule to cover other legal entities. Specifically, investment advisers were allowed to count a legal organization as a single client provided the investment advice was based on the objectives of the legal organization rather than the individual investment objectives of any owners of the legal organization. This safe harbor allowed investment advisers to manage large amounts of securities indirectly for several hundreds of investors in several hedge funds.
After the fall of Long Term Capital Management (LTCM) in 1998 and its bailout orchestrated by the New York Federal Reserve Bank, it became increasingly apparent that hedge funds could pose risks that might affect international markets. Concerns over excessive leverage by hedge funds and a lack of transparency led to increasing demands for new regulation. Central banks, regulatory agencies, and international regulatory committees conducted studies to determine if hedge funds posed a risk to the global financial system. Many of these studies concluded that there was a need for greater disclosure by hedge funds to increase transparency and enhance market discipline.
Eventually, in December 2004, the SEC, using its rulemaking authority under the Investment Advisers Act, issued a final rule requiring hedge fund advisers to register under that act. The rule was controversial and strongly opposed by hedge fund advisers. Without the private adviser exemption, investment advisers were subject to SEC inspections and bookkeeping and record keeping requirements. Without the private adviser exemption, hedge funds were also faced with disclosure requirements and code of ethics requirements resulting in significantly higher legal fees. The industry argued that completing the 35-page Form ADV was unnecessarily costly and burdensome. Registration also allowed the SEC to screen hedge fund advisers for prior convictions or other professional misconduct.
The rule was issued by a rare three-to-two vote of the SEC Commissioners. The SEC justified its rulemaking with reference to the growth of the hedge fund industry in combination with the retailization of the hedge fund sector, increased hedge fund risk, and financial loss to investors caused by instances of fraud by hedge fund advisers. It cited among the benefits of this rule more information about hedge fund advisers, the deterrence of fraud, the curtailment of losses, and improved compliance controls. The SEC argued that these positive aspects of its rulemaking would benefit mutual fund investors, other investors and markets, regulatory policy, and hedge fund advisers.
The registration requirement precipitated significant opposition by the hedge fund industry. Eventually, in July 2006, the D.C. Circuit in Goldstein v. SEC vacated the hedge fund rule as an instance of arbitrary rulemaking by the SEC. Because the term “client” had not otherwise been defined in the Investment Advisers Act, the SEC had no authority to determine the meaning of the term. Most hedge fund advisers who had registered under the registration rule deregistered. After the Goldstein decision, the SEC proposed a tightening of accredited investor standards under Regulation D, the primary method of raising hedge fund cash, and expanded antifraud protection for private investors.
The Dodd-Frank Act mooted the Goldstein decision by authorizing explicitly the SEC to register hedge fund advisers. Title IV of the Dodd–Frank Act is entitled the Private Fund Investment Advisers Registration Act of 2010 (PFIARA). PFIARA authorizes the SEC to bring hedge funds under regulatory supervision. The Dodd-Frank Act authorized the SEC to promulgate rules requiring registration and enhanced disclosure for private equity and hedge funds managers. As part of the new rules, the SEC introduced controversial reporting obligations that would require the disclosure of strategies and products used by the investment adviser and its funds, performance and changes in performance, financing information, risks metrics, counterparties and credit exposure, positions held by the investment adviser, percent of assets traded using algorithms, and the percent of equity and debt, among other matters.
The Act mandates hedge fund adviser registration to increase record keeping and disclosure. Under PFIARA, hedge funds with more than $150 million Assets Under Management (AUM) are required to register as investment advisers and to disclose information about their trades and portfolios to the SEC. The Dodd-Frank Act also directs the SEC to set up rules for the registration and reporting of hedge fund managers who were previously exempt from registration. By registering hedge fund advisers, the SEC may collect necessary information to curtail those who operate in the “shadows of our markets,” prevent fraud, limit systemic risk, and provide information to investors.
Title IV of the Dodd-Frank Act also requires registered investment advisers to maintain records and any other information that may be necessary and appropriate to avoid systemic risk. Advisers are required to provide confidential reports with respect to certain information related to systemic risk, such as trading practices; trading and investment positions; the amount of AUM; valuation policies; side letters; the use of leverage, including off-balance sheet leverage; counterparty credit risk exposures; and other information deemed necessary. PFIARA also makes it mandatory for registered advisers to maintain records and any other information the SEC and the systemic risk regulators may deem necessary.
Despite these challenges for the hedge fund industry, several empirical studies conducted by Professor Wulf A. Kaal suggest that the impact of Form PF has been absorbed relatively quickly by the hedge fund industry. The hedge fund industry seems to be adjusting well to the registration and disclosure requirements under the Dodd-Frank Act. Kaal’s data analysis indicates, however, that the data reporting requirements for hedge fund advisers in Form PF and the corresponding SEC forms can be further improved. The majority of SEC-registered hedge fund advisers identified the ambiguity of Form PF data reporting requirements as the most pressing issue. Kaal also shows that the cost of hedge fund manager registration under the Dodd-Frank Act brings increasing returns to scale for the industry, favoring the larger established funds.
The newest regulatory threat to hedge funds, advocated by the leading candidates in both the Democratic and Republican Presidential primaries, is a change in the tax code which would, if enacted, dramatically increase the taxes paid by successful hedge funds on their returns. The increased taxes, unless ameliorated though clever planning, could reduce substantially hedge fund returns and make them less competitive to other forms of intermediated investments.
SUMMARY AND CONCLUSIONS
Financial economists have, for over seventy years, been decrying the lack of independent shareholder involvement in the management of public firms and the lack of swift capital reallocation in American industry. Hedge funds play a major role in both of these functions.
In the aftermath of Title IV of the Dodd-Frank Act, the SEC’s fine tuning of the regulatory framework applicable to the hedge fund industry can further enhance hedge funds’ role in financial markets.
The preceding post comes to us from Wulf A. Kaal, Associate Professor at the University of St. Thomas School of Law, and Dale A. Oesterle, the J. Gilbert Reese Chair in Contract Law at the Moritz College of Law at The Ohio State University. This post is based on the co-authored article: Wulf A. Kaal & Dale Oesterle, The History of Hedge Fund Regulation in the United States, Handbook on Hedge Funds, Oxford University Press (2016), which is available here.